A criticism of accountants is that they too often get caught up in the details and miss the ‘big picture’ of business. This week we are going to take steps to address this criticism by taking a look at key business decisions and
the role that accounting plays in reporting them. Some simplifications are necessary but it does provide a nifty overview of how accounting explains the major decisions that a business owner is making.
Do you know what the point of a balance sheet is?
In this post, the first step to answering this question, however, we will be taking a few weeks to build towards an answer.
Prof Mark Graham, a colleague who lectures the UCT MBA & UCT Board Course accounting modules, introduces this diagram to his classes every year (see diagram below). It tells the whole story. The starting point is the business entity in the center. The business entity could have a number of legal forms – public company, private company or close corporation.
What is the goal?
There is a large amount of debate around the central goal of a business entity but I would advocate increasing shareholder value as being primary. Other goals like employee engagement, environmental sustainability or value creation for stakeholders do not need to be competition with this goal but should not be primary.
What is the business idea?
It is vitally important that the central value creation idea of the business entity is a good one. No matter how good the accountant, supply chain manager or management team, if the value creation idea is poor, the business entity will not survive for long. Selling ice to Eskimos or Bafana Bafana 2014 FIFA World Cup memorabilia would clearly not be great ideas.
The four major decisions:
Once the business entity has an idea that is expected to increase share- holder value, there are four major decisions that need to be made:
1. Financing decision
There is a need for finance. There are two sources of finance. Debt will need to be repaid and has an interest charge. It also usually requires some security to be provided. Equity represents the owners investing their own money or asking others to give finance in exchange for a share in the business entity. Equity doesn’t need to ever be repaid but it is ownership of all the future profits of a company and thus can grow to become incredibly valuable. For instance, American artist David Choe was offered cash or shares in
Facebook
after he painted a mural in its first corporate headquarters. He chose the shares. They were worth approximately $200m when Facebook listed last year.
2. Investing decision
Once finance has been raised, management will invest. Assets should help the operations of the entity and can consist of items like inventory, a factory or delivery vehicles. Those assets that are expected to give benefit for longer than a year are classified as non-current (a property or vehicle) while the others would be classified as current (inventory or accounts receivable).
3. Operating decision
There are numerous decisions lumped together here. The price that will be charged, the distribution model and the marketing mix to name a few. Hopefully all of these operating decisions result in income exceeding expenses for the year and therefore a profit being reported.
4. Dividend decision
It is important to note that not all profit is converted into cash straight away. For instance, a store that sells clothes on credit would record a profit on the day the customer leaves the store with the clothes but will sometimes only receive cash six months later. For that reason, it is vital to observe cash inflows and outflows and not just profit. The final decision revolves around how much cash to return to shareholders by way of a dividend. The funds that are not returned as a dividend are kept within the business entity. They are effectively completing the loop by becoming a source of finance for further investments.
How do these four decisions relate to the financial statements prepared by accountants?
The Balance sheet or statement of financial position
Take a look at the block around the financing and investing decision on the diagram. That is the balance sheet. It shows the debt, equity and assets of a business entity and reflects the financing and investing decisions taken by management up until that on a specific date. This was the first financial statement invented, but soon people became interested in what happened between balance sheet dates and demand grew for a statement that would give an indication of financial performance.
The income statement or statement of comprehensive income
The outcomes of all the operating decisions are reflected primarily in the income statement. It is impossible to whittle down performance in a year to one number but a profit or loss for the year tries to do that.
The cash Flow statement or statement of cash flow
Finally, there was demand for a statement that would only show cash flows (see block 4). We have already looked in previous articles at how this statement can be used to identify those companies that generate excess cash (BAT and SAB) and those that require more cash to be invested to keep operating (SAA).
All three of these statements form the cornerstone of the useful information that financial statements provide and that influences business decisions. I hope that this ‘big picture’ helps you gain context for their importance.
source:finweek
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